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In 2005, Sy Jacobs sold his New York City loft and rented a town house. A hedge-fund manager specializing in financial stocks, Jacobs was troubled by what he saw as an impending train wreck in real estate, due to the worsening credit bubble. With calls like that, it's no surprise that Jacobs has compiled an impressive record steering his market-neutral hedge fund, JAM Partners. Since its inception in April 1995 through the end of March, the hedge fund, which is closed to new investors, has an annual return of 13.4%, net of fees and expenses, versus 8.6% for the Standard & Poor's 500 index. The New York firm oversees more than $600 million, spread across the hedge fund and several private-equity portfolios.

Nowadays, Jacobs is much more upbeat about the banks, citing improved credit quality among the survivors. He recently bought a Manhattan town house, testament to his more bullish sentiments. Jacobs, 52 years old, began his career in 1985 on the sell side as a bank analyst at Salomon Brothers. Barron's spoke with him recently by telephone.

Barron's: Take us back to 2005 for a minute and talk about why you became very skeptical about banks and other financials.

Jacobs: We got very bearish on what low interest rates under the Greenspan Fed regime—and then its attempts to raise them—had wrought in terms of loose credit and the bursting of that bubble. The problem originated in subprime, but it radiated out from there. We were flummoxed by this notion that it could be contained or "ring fenced," which was the popular euphemism at the time.

"The credit pig has been passing through the bank python, and the loans that were made post-2008 have been of much better quality." -- Sy Jacobs
Roger Hagadone for Barron's

That ring-fence notion seemed absurd to us. But you had Greenspan and then [current Federal Reserve Chairman Ben] Bernanke, all their followers, and the market taking the opposite side of our bet. So in the first interview I did with Barron's, in 2005, I said that the financial markets would be dominated by the bursting of the housing bubble and its aftermath for the next 10 years, and that's largely played out. We don't typically like to even express a macro view in our portfolio, and we are not a global macro shop. We're a sector fund, strictly in financials. But in that era, we got so bearish about credit within our mortgage focus, and it only secondarily occurred to us that it must have systemic implications for the economy.

How do the banks look to you now?

I see it as a pig-in-the-python analogy. In other words, the credit pig has been passing through the bank python, and the loans that were made post-2008 have been of much better quality. So we are destined to have improving and benign credit comparisons for the next several years. For surviving institutions, credit quality is now a tail wind. We consider the crisis to be over, from a credit-quality point of view, and we've gone back to our comfort zone, which is market-neutral investing in our hedge fund and long-term investing in our private-equity fund.

What about the economy worries you?

All the tools that were used to combat the contagion revolved around massive amounts of fiscal and monetary stimulus. So my fear is that we have a slightly different version brewing of the same kind of misallocation of resources that Greenspan started after Long-Term Capital Management and the tech bubble bursting—that is, pushing interest rates too low and causing distortions in economic behavior. It is manifesting itself now in a liquidity and bond bubble, instead of a housing bubble. So our concern is less specific to housing and mortgages and more generalized to the unintended consequences of excess liquidity and low interest rates.

Turning to banks, what's your view of the sector?

We have had a slightly bullish bias lately, given the credit wind at the back of the financial markets. But the trend we are most excited about is that we see a strong likelihood of a big consolidation in the community-bank business in the U.S. The country is overbanked and overbranched. Consolidation has actually slowed down a lot since the crisis hit. So this isn't happening yet. But the regulatory response to the crisis is going to cause consolidation to pick up again as banks are now feeling increased costs and burdens of the new regulatory regime. So it is especially bad for small banks, which have seen their fixed costs lurch up but whose costs are spread over smaller asset bases.

Community banks typically have low-cost, local deposits for giving higher-touch service in their communities. But with falling rates, they have seen their asset yields reprice down faster than their deposit costs, because their deposit costs were already zero or close to zero, in many cases. So cost pressure and net-interest margin pressure is the current state of affairs in U.S. community banking, along with low growth because the economy is weak. There are 7,100 banks and close to 100,000 bank branches in the U.S., and more than 90% of those banks have under $1 billion of assets. To put that in perspective, the largest bank,
JPMorgan ChaseJPM 0.43468045112781956%JPMorgan Chase & Co.U.S.: NYSEUSD85.49
0.370.43468045112781956%
/Date(1481320816956-0600)/
Volume (Delayed 15m)
:
14283053AFTER HOURSUSD85.48
-0.01-0.011697274535033338%
Volume (Delayed 15m)
:
284149
P/E Ratio
14.739655172413793Market Cap
304581834359.245
Dividend Yield
2.245876710726401% Rev. per Employee
421457More quote details and news »JPMinYour ValueYour ChangeShort position
[ticker: JPM], has more than $2 trillion of assets. So banks under $1 billion in assets, which is almost all of the banks in the country, are under a lot of cost and margin pressure. Most are not earning their cost of capital and have little prospect of doing so. So banks under $1 billion have higher expense ratios and lower profitability than those above $1 billion. And the only way out of it is through sales and mergers, where the buyer gets cost efficiencies and greater market share and, thus, pricing power. Another side effect of the financial crisis is that there is now wide support to end too-big-to-fail. So I don't expect megabanks to be allowed to be created through mergers anymore. The consolidation is going to happen from the bottom.

What are some banks that illustrate the consolidation trend?

Provident New York Bancorp
[PBNY] is doing a merger of roughly equals with
Sterling BancorpSTL -0.4098360655737705%Sterling BancorpU.S.: NYSEUSD24.3
-0.1-0.4098360655737705%
/Date(1481320855278-0600)/
Volume (Delayed 15m)
:
920165AFTER HOURSUSD24.3
%
Volume (Delayed 15m)
:
11629
P/E Ratio
24.059405940594058Market Cap
3298465115.66811
Dividend Yield
1.1522633744855968% Rev. per Employee
473546More quote details and news »STLinYour ValueYour ChangeShort position
[STL]. Both are in the New York metropolitan area. Sterling's assets total $2.8 billion; Provident has $3.7 billion of assets. They are doing a stock swap. So shareholders of both companies are winners, as a share of the combined company will have more earnings power, after redundant costs are wrung out, than a share of either of the individual banks would have had alone. The combined entity will have a stronger, more scalable market presence. Both banks, especially Sterling, have a very low-cost deposit base, and both banks have been hurt badly by lower rates. So if my rising inflation and interest-rate scenario plays out, that will help the bank's margins. Once fully integrated in 2014, Sterling, as it will be called, can be a serial and accretive acquirer of other banks in the area. The combined bank will have about $7 billion of assets and about a $750 million stock-market cap.

Provident, which is technically the buyer, is trading around $8.90 a share. We expect them to earn about 58 cents a share in 2013, their last year of independence, about 75 to 80 cents a share next year and nicely higher in 2015—the first full year in which the company will have the entire cost savings and integration in place.

Could you talk a little more about how these banks complement each other?

Sterling is more Manhattan and the boroughs. Provident is more Westchester and Rockland counties, but they both have branches in the city and its suburbs. So it is a really good combination. The synergies will come from a lot of cost savings, which include closing some branches and back-office cuts. And there is the heft that comes from going from two small players to a larger player in the New York City market, which is a concentrated and lucrative commercial-banking market. There will be revenue synergies, as well as cost savings. We owned Sterling before the deal and have been buying both since it was announced in early April, because we like the combination so much.

What's another stock that illustrates your consolidation thesis?

Berkshire Hills BancorpBHLB 0.5517241379310345%Berkshire Hills Bancorp Inc.U.S.: NYSEUSD36.45
0.20.5517241379310345%
/Date(1481320921048-0600)/
Volume (Delayed 15m)
:
194962AFTER HOURSUSD36.45
%
Volume (Delayed 15m)
:
1662
P/E Ratio
17.440191387559807Market Cap
1128788747.78748
Dividend Yield
2.1947873799725652% Rev. per Employee
279884More quote details and news »BHLBinYour ValueYour ChangeShort position
[BHLB], headquartered in Pittsfield, Mass., has expanded through acquisitions into upstate New York, Vermont, and northern Connecticut. So they have a head start on what we expect is going to happen in the industry. They've done four accretive acquisitions in the past two years, and they've become a $5.5 billion bank in assets. The management team is excellent, they have a deep bench, they are smart enough to run a much larger bank, and they are very shareholder-value-oriented. An interesting twist is that Larry Bossidy, a longtime GE executive who went on to run Allied Signal and
Honeywell InternationalHON 0.5015131863380891%Honeywell International Inc.U.S.: NYSEUSD116.23
0.580.5015131863380891%
/Date(1481321002424-0600)/
Volume (Delayed 15m)
:
2905200AFTER HOURSUSD116.38
0.150.12905446098253462%
Volume (Delayed 15m)
:
10137
P/E Ratio
18.390822784810126Market Cap
88139757412.9105
Dividend Yield
2.2885657747569472% Rev. per Employee
304643More quote details and news »HONinYour ValueYour ChangeShort position
[HON], was the chairman of the bank's board until recently and now serves as the lead director. He happens to be from Pittsfield. And he has mentored the much younger and, in our view, excellent CEO of Berkshire Hills, Michael Daly, and that's one of the reasons why we see this as an institution girded to be much bigger and more powerful.

What kind of earnings can the bank put up?

The market cap is $650 million, and the stock is at $25 and change. We estimate they will earn $2.25 a share this year and grow that at double digits for years to come as they roll up banks in their broad market. They, too, have been hurt by falling interest rates, so the $2.25 is below their current earnings power, but the earnings growth will start getting reflected in the stock price. They can use the stock for more acquisitions to create a virtuous cycle of earnings accretion and growth. The most logical acquisition target for Berkshire is
United Financial Bancorp UBNK 0.7150715071507151%United Financial Bancorp Inc.U.S.: NasdaqUSD18.31
0.130.7150715071507151%
/Date(1481320800288-0600)/
Volume (Delayed 15m)
:
138362AFTER HOURSUSD18.31
%
Volume (Delayed 15m)
:
2546
P/E Ratio
20.344444444444445Market Cap
918308194.278565
Dividend Yield
2.6215182960131074% Rev. per Employee
347788More quote details and news »UBNKinYour ValueYour ChangeShort position
[UBNK], a $2.4 billion bank in West Springfield, Mass. Its market cap is about $300 million, and there are lots of branch overlaps, so the cost savings would be large and accretive. We own UBNK as well. It trades at $14.66 a share. We think it's worth more, but would happily swap our UBNK shares, even in a little or no-premium deal, for Berkshire Hills shares, because the new shares would have much better earnings power and growth prospects than a share of UBNK has now. I actually think that it could happen, because United Financial's CEO, Richard Collins, is 70 years old, and CEOs reaching retirement are often a catalyst for mergers and acquisitions. And it should happen, because the logic of the combination is compelling for both sets of shareholders.

How has Berkshire Hills financed its acquisitions?

Mostly stock and some cash deals. They do it in a proportion that keeps capital ratios above the minimum requirement. But it is largely stock swaps, and that's why this roll-up math is so important. If they generate earnings accretion and growth, then the stock gets rewarded. These stocks are undervalued and are going to move up.

What other bank stocks look interesting?

Another of our favorite consolidation plays is
OFG BancorpOFG -1.048951048951049%OFG BancorpU.S.: NYSEUSD14.15
-0.15-1.048951048951049%
/Date(1481320925763-0600)/
Volume (Delayed 15m)
:
420642AFTER HOURSUSD14.15
%
Volume (Delayed 15m)
:
3520
P/E Ratio
21.76923076923077Market Cap
627970229.323197
Dividend Yield
1.696113074204947% Rev. per Employee
307151More quote details and news »OFGinYour ValueYour ChangeShort position
[OFG] in Puerto Rico. Puerto Rico boomed and busted even more dramatically, I'd say, than the U.S. housing market did in general. But OFG was more of a mortgage-backed-securities portfolio funded by bank deposits in Puerto Rico, so it actually avoided the credit problems of its peers. Then they bought Eurobank, one of the failed banks on the island, in 2010, and last year, in a very opportunistic deal, they bought another of their competitors in Puerto Rico from
Banco Bilbao Vizcaya ArgentariaBBVA -1.4513788098693758%Banco Bilbao Vizcaya Argentaria S.A. ADRU.S.: NYSEUSD6.79
-0.1-1.4513788098693758%
/Date(1481320840867-0600)/
Volume (Delayed 15m)
:
2498909AFTER HOURSUSD6.75
-0.04-0.5891016200294551%
Volume (Delayed 15m)
:
209722
P/E Ratio
10.569738480697385Market Cap
45139767491.0367
Dividend Yield
5.120942562592047% Rev. per Employee
198197More quote details and news »BBVAinYour ValueYour ChangeShort position
[BBVA], the Spanish bank that is retrenching from problems in its home market.

Jacobs' Picks

Recent

Company

Ticker

Price

Berkshire Hills Bancorp

BHLB

$25.59

United Financial Bancorp

UBNK

14.66

OFG Bancorp

OFG

15.96

Old National Bancorp

ONB

12.03

Source: Bloomberg

So, suddenly, between these two deals, OFG is the second-largest and cleanest bank in Puerto Rico, and it is the best-positioned to take advantage of less competition and a stabilizing economy. The stock is around $16. We expect them to earn $1.60 this year and to be at $2 run rate by the end of next year, when all the BBVA cost savings are factored in—and that's with recessionary economic conditions in the assumption. There is lots of earnings leverage and upside in a recovery in Puerto Rico.

What about another bank?

Old National BancorpONB 1.392757660167131%Old National BancorpU.S.: NasdaqUSD18.2
0.251.392757660167131%
/Date(1481320800181-0600)/
Volume (Delayed 15m)
:
1015654AFTER HOURSUSD18.2
%
Volume (Delayed 15m)
:
14879
P/E Ratio
16.760291002854775Market Cap
2423339940.64713
Dividend Yield
2.857142857142857% Rev. per Employee
236896More quote details and news »ONBinYour ValueYour ChangeShort position
[ONB] is now just under $10 billion in assets, after buying from the FDIC a failed rival down the street, Integra Bank, in Evansville, Ind. They also have bought two healthy banks elsewhere in Indiana in the past two years. And they recently announced an agreement to buy the northern Indiana and southwest Michigan branches of
Bank of AmericaBAC 0.6100217864923747%Bank of America Corp.U.S.: NYSEUSD23.09
0.140.6100217864923747%
/Date(1481320861068-0600)/
Volume (Delayed 15m)
:
128607713AFTER HOURSUSD23.08
-0.01-0.043308791684711995%
Volume (Delayed 15m)
:
1982693
P/E Ratio
19.24968736973739Market Cap
232342244198.49
Dividend Yield
1.2992637505413598% Rev. per Employee
432244More quote details and news »BACinYour ValueYour ChangeShort position
[BAC], which is going through its own branch retrenchment. That's going to be the beginning of Old National consolidating the southern Michigan bank market, and Old National is a proven acquirer.

We expect they will be an accretive roller-upper for years to come. The stock is around $12, and the bank will earn a $1.05 this year, with good earnings growth from there if they continue to acquire banks accretively.